Portfolio Commentary

Review and Outlook (for quarter ended 12/31/2014)

The fourth quarter featured broad swings in stock prices and currencies, with international equities ultimately retreating through the year-end and leaving the key related indices slightly down for the full year (in dollar terms). The fourth quarter also marked a return to a macro-driven market environment, dominated by key variables including monetary policy expectations, the U.S. dollar, and the price of oil.

A critical question for the global capital markets remains whether the multi-year offensive against deflation and deleveraging in most key economies will achieve lasting success. In the recent quarter, economic weakness and deteriorating inflation readings in Europe, Japan, and China raised enough doubt to force the Bank of Japan, the ECB, and China’s authorities to “reload” expectations of aggressive monetary and fiscal support. Of course such moves, when juxtaposed with a strengthening U.S. economy and a tighter Fed, undermine the host currencies against the dollar. In our view, a material rise in the dollar suggests the specter of deflation, and generally coincides with weak commodity and oil prices, and often, falling interest rates. The developed markets remain challenged by sluggish economic growth and very low inflation alongside fairly high debt-to-GDP levels. Current conditions also represent an obvious challenge for emerging markets, particularly those with significant commodity-based exports and/or U.S. dollar borrowings. As such, we would not be surprised to see a crisis in a commodity exporting country, as we have likely already seen initiated in Russia and/or Venezuela. Again, we ask whether the complacency suggested by record low sovereign bond yields just months ago was fundamentally based. We anticipate the standard deviation of returns among countries, currencies and sectors will remain wide for the time being.

To us, this is where the benefit of active management comes into focus. Recent macroeconomic developments support a dichotomy of relative outcomes, and we suspect those countries and companies benefitting from weaker oil and commodity prices, and/or generally insulated from a rising cost of capital, will continue to experience relative strength in currency values and equity prices. We believe we remain well-positioned for such an environment. Our theme-based and bottom-up process identifies what we believe to be value-creating management teams and companies with strong fundamental outlooks – often strong enough to weather difficult macroeconomic headwinds. Several market-friendly and value enhancing reforms are underway across our markets, particularly in those countries and industries in which we are most heavily invested. We believe these reforms are highly likely to advance to implementation, with value creation to follow.

Finally, we reiterate that the ongoing shift in opportunity, resources and capital towards those international companies and entrepreneurs most capable of driving economic efficiency and productivity remains on course. We believe this trend underlies the Fund’s strong performance to date, and we remain enthusiastic regarding the long-term prospects for the many companies in which we are invested.

Top Contributors/Detractors to Performance

Contributors(for quarter ended 12/31/2014)

The contributors to performance for period ending December 31, 2014 is not yet available

Detractors(for quarter ended 12/31/2014)

The detractors to performance for period ending December 31, 2014 is not yet available

Quarterly Attribution Analysis (for quarter ended 12/31/2014)

When reviewing performance attribution on our portfolio, please be aware that we construct the portfolio from the bottom up, one stock at a time. Each stock is included in the portfolio if it meets our rigorous investment criteria. To help manage risk, we are aware of our sector and security weights, but we do not include a holding to achieve a target sector allocation or to approximate an index. Our exposure to any given sector is purely a result of our stock selection process.

Stock selection in developed markets modestly added value, driven by outperformance of the Fund’s holdings in Germany, the U.K., and Ireland, but this positive effect was somewhat offset by weakness in Norway and Japan. The Fund’s investments within emerging markets outperformed their benchmark counterparts by 835 basis points, led by those in India, Brazil, and China. The Fund’s lower exposure to Russian equities, which fell sharply in the quarter because of the Russian Ruble’s depreciation and a challenging macro environment, aided relative results.

On a sector basis, outperformance of the Fund’s investments within Industrials, Financials, and Materials, and its larger exposure to the only sectors in the index to appreciate during the quarter, Consumer Discretionary and Information Technology (IT), contributed the most to relative results. Within Industrials, airline stocks performed well due to falling jet fuel prices and strong fundamentals (load factors and ticket pricing), and the Fund’s larger exposure to this sub-industry aided relative results. More than half of the Fund’s investments in the Consumer Discretionary sector outperformed as falling oil prices led investors to anticipate increases in discretionary spending. The largest contributors to relative performance in the sector were AO World plc and Domino’s Pizza Group plc of the U.K. Strength in Financials was primarily attributable to the outperformance of Haitong Securities Co., Ltd., a leading Chinese securities and brokerage firm, as results from financial reform emerged and China announced new stimulus measures. Axis Bank Ltd. of India and PATRIZIA Immobilien AG of Germany also drove outperformance in the sector. All four of the Fund’s holdings in the Materials sector outperformed, with Symrise AG of Germany contributing the most. Shares of Symrise, one of the largest manufacturers in the global flavor & fragrance industry, rose helped by solid quarterly results.

The Fund’s investments within the Energy sector were the largest detractors from relative performance. Weakness in the sector was mainly due to the underperformance of the Fund’s oil & gas exploration and production holdings, led by Premier Oil plc and Crescent Point Energy Corp., and its larger exposure to this sub-industry, which suffered as a result of falling oil prices. The Fund’s larger exposure to the lagging oil & gas drilling stocks, with its investment in Seadrill Partners, LLC, also hurt relative results.

Yearly Attribution Analysis (for year ended 12/31/2014)

Within developed markets, significant gains from the Fund’s holdings in Germany, Australia, and France were mostly offset by the underperformance of its Japanese investments, which fell 22.3% as a group during the year. Strong stock selection within emerging markets added the most value, led by the Fund’s investments in Brazil and Indonesia. Following Narendra Modi’s victory in India’s general election this past spring, Indian equities outperformed as investors anticipated market friendly reforms, and the Fund’s larger exposure to India aided relative results. In addition, its lower exposure to Russia, where currency depreciation and falling oil prices weighed on equities, contributed to relative performance.

On a sector basis, the Fund’s investments within the Consumer Discretionary, Information Technology (IT), and Industrials sectors were the largest contributors to relative results. Within Consumer Discretionary, outperformance of the Fund’s Brazilian education services holdings added the most value. The Brazilian antitrust authority approved the merger agreement between Kroton Educacional SA and Anhanguera Educacional Participações SA in May, which creates one of the largest for-profit education companies in the world. Also, post-secondary education company GAEC Educação SA was a new addition to the Fund late in the year, and the stock increased 13.5% for the period held. Strength in the sector was also attributable to the outperformance of Smiles SA, the Fund’s largest contributor on an absolute basis, and the Fund’s two restaurant investments, Domino's Pizza Enterprises Ltd. and Domino's Pizza Group plc. Domino’s Pizza Enterprises is the master franchisee of the Domino’s Pizza brand in Australia, New Zealand, select European countries, and Japan, while Domino's Pizza Group is the master franchisee in the U.K., Ireland, Germany and Switzerland. Both companies benefited from exceptional performance in their home markets. Within IT, outperformance of the Fund’s application software holdings contributed the most to relative results. The Fund’s application software investments, which account for more than 28% of its exposure to the IT sector, increased 30.5% as a group, led by Constellation Software, Inc. of Canada and RIB Software AG of Germany. Constellation was one of the Fund’s largest contributors to absolute performance, while RIB benefited from a jump in new contracts following the company’s efforts to shorten its sales cycle by allowing new clients to try its software in mobile labs. Within Industrials, the Fund’s airline holdings outperformed, driven by the same factors that drove performance for the fourth quarter.

The Fund’s investments within the Health Care and Energy sectors were the largest detractors from relative results. Within Health Care, the Fund’s lack of exposure to outperforming pharmaceutical stocks and the underperformance of Grifols SA, a Spanish plasma products company, detracted the most from relative results. Shares of Grifols SA declined after quarterly results were hurt by one-time expenses and price competition in a small product line. Within Energy, underperformance of Premier Oil plc and Crescent Point Energy Corp. hampered relative results.

The prospective performance of the companies discussed herein is based on our internal analysis and reflect our opinions only. We cannot promise future returns and our opinions are a reflection of our best judgement at the time of publication. Our views are not intended as recommendations or investment advice to any person and are subject to change at any time based on market and other conditions and Baron has no obligation to update them. Investing in the stock market is always risky. Current and future portfolio holdings in the Fund are subject to risk.

You should consider the investment objectives, risks, charges, and expenses of any of the Baron Funds carefully before investing. The prospectus contains this and other information about Baron Funds. You may obtain one from its distributor, Baron Capital, Inc., by calling 1-800-99BARON or click here. Please read it carefully before investing.